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401K Withdrawal For Debt Relief – A Good Idea?

April 16, 2012 0 comments

by Lizzy Bale

Amassing a large debt can have several unintended consequences. One of those consequences is an early raiding of your retirement fund. Taking this bold action should not be done without thinking about what kind of impact this will have on your future. You need to consider all the costs of an early withdrawal from your 401K for debt relief.

You Have To Pay Income Tax on An Early 401k Withdrawal

Most of the money that you put into your 401K is going to be tax-free. As such, you have to pay tax on that money when you withdraw it. This is because the money you are taking out will now be considered taxable income for the year. Borrowing from your retirement fund could even bump you up to the next tax bracket which will cost you even more.

Say you earned $15,000 last year. This would put you squarely in the 10 percent tax bracket. Borrowing $10,000 form your 401k will push you up to $25,000 earned for the year. This will put a portion of your income into the 15 percent tax bracket. That extra tax will be on top of the income taxes you are already paying after deductions.

Using your 401K to pay for a debt settlement could make your situation even worse. Any portion of your forgiven debt over $600 may be subject to income taxes as well. You could very well be taxing yourself twice just to get out of debt.early 401k withdrawal

There Are Extra Penalties As Well

You must pay an additional tax of 10 percent of any amount you borrow before age 59 1/2. This means you would owe a penalty of $1,000 if you were to borrow $10,000. It is good to know that this tax is placed on top of any other income taxes you pay on the early withdrawal.

A tax of up to 25 percent may be applicable to anyone who withdraws from a SIMPLE IRA. Your penalty would then be $2,500 if you were to borrow $10,000. This extra penalty should be taken into account before deciding to sacrifice your retirement to help yourself today.

You could borrow money from your 401k as a loan to yourself. Doing so could restrict you from contributing to your account while repaying the loan. You may be limited to taking out 50 percent of the amount in your account.

Losing Compounding Interest Will Make It A Bad Idea

Taking money out of your account is going to cost you in the form of future interest. Your retirement fund gains compounding interest during the life of the account. Compounding interest can yield thousands of extra dollars for your retirement.

The basic principle behind compounding interest is that each dollar of interest will gain interest by itself. For example, say you put $100 in your account in 2010 with a 10 percent rate of return. The initial investment will give you $10 a year. However, that next $10 will also gain 10 percent each year.

Total funds in your account in 2011 would be $110 because 100 + 10 = 110. Total funds in 2012 would be $121 because 110 + 10 + 1 = 121. You can see how compounding interest is beneficial for your money as it grows over time. Simply losing the ability for your money to grow without having to work for it should convince you to stay away from your 401K for any debt relief plans.

Exceptions To The Rule

There are a few exceptions to the rule that may save you from a majority of the costs related to early withdrawal. You may be able to avoid paying income tax for withdrawals related to a home purchase, tuition expenses or funeral costs. These are all referred to as hardship withdrawals.

You may need to pay the 10 percent penalty even if your situation does qualify as a hardship. It also will not solve your problem of having less money to accrue interest with.

Taking money from your retirement to pay off debts today is not usually your best route. It could be a better idea to talk to a credit relief counselor about a settlement instead. Call today to speak to a specialist who can help you decide which debt relief option would be best for you. Find out now how much a debt settlement can save you.


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